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A Midstream Update

Global dynamics in the energy space continue to grab headlines: will OPEC renew its production cuts, will domestic shale producers cause another commodity crash, will demand overcome aggregate estimates?

The reshaping of the energy landscape is still working its way toward a new global order and more stable parameters.  The price war that Saudi Arabia escalated over two years ago has ushered in a new era of price volatility at the commodity level but it has also made most of the industry more resilient and more efficient.

At the domestic level, the shorter cycle shale production has significantly lowered its break-even points for crude and unlocked significantly large natural gas production.  Nevertheless, another commodity crash would seem unlikely as local producers might have to be more disciplined in order to retain access to capital markets and because eventually the massive cuts made in capex for longer cycle exploration and production will begin to bite. Additionally, the International Energy Agency also projects increases in demand beyond average estimates. All this should translate in a volatile crude oil yet locked in a wide price range between $40 and $60.

This could be a sweet spot for midstream operators in the US. Such a price range will ensure steadily increasing volumes which will need additional pipelines and storage.  While pipelines and commodity can experience a much higher than usual correlation during massive price changes (up or down), they tend to be much less correlated during most other contingencies.  In fact, correlations are usually higher between pipelines and volumes than commodity prices.  This can be witnessed by looking at the lack of correlation between midstream companies and natural gas during the price correction gas witnessed from the highs hit in 2008.

On natural gas, the domestic abundance of the commodity is sparking a globalization of what historically was a very fractionalized and regional market.  Exports of Liquefied Natural Gas (LNG) should help create a global price for gas and create a new revenue stream for US producers and exporters. Year to date the midstream sector has been uncommitted. A rally in the first 6 weeks was undone in the second part of the quarter.  While current valuations remain attractive and the longer term story very interesting, investors are shy to anticipate catalysts after the punishing action of 2015 and the beginning of 2016.

The burden of proof is on execution and that may require a couple of quarters to become ingrained in the investment community.  In the meantime, patient investors may continue to enjoy a current yield around 6.5% which is considerably higher than the 10 year US Treasury yield of 2.34% or the roughly 5% paid by High Yield bonds (source: BofA Merrill Lynch US High Yield Options Adjusted Spread).

Some other trends that should continue to provide a tailwind in 2017 are: consolidation and IDR elimination, ethane recovery, increased capex focus on downstream projects, more balance sheet healing.

Our investing focus will remain on natural gas, LNG exports and stronger balance sheets.